Updated CRS Report 12-13-12

7/30/2019 Updated CRS Report 12-13-12

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CRS Report for CongressPrepared for Members and Committees of Congress

Taxes and the Economy: An Economic

Analysis of the Top Tax Rates Since 1945

(Updated)

Thomas L. HungerfordSpecialist in Public Finance

December 12, 2012

Congressional Research Service

7-5700

www.crs.gov

R42729


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Taxes and the Economy: An Economic Analysis of the Top Tax Rates Since 1945


Summary

Income tax rates are at the center of many recent policy debates over taxes. Some policymakersargue that raising tax rates, especially on higher income taxpayers, to increase tax revenues is part

of the solution for long-term debt reduction. For example, in the 112

th

Congress the Senate passedthe Middle Class Tax Cut (S. 3412), which would allow the 2001 and 2003 Bush-era tax cuts toexpire for taxpayers with income over $250,000 ($200,000 for single taxpayers). Otherpolicymakers argue that maintaining low tax rates is necessary to foster economic growth. Forexample, the House passed the Job Protection and Recession Prevention Act of 2012 (H.R. 8),which would extend the 2001 and 2003 Bush-era tax cuts for one year. The Senate alsoconsidered legislation, the Paying a Fair Share Act of 2012 (S. 2230), that would implement theso-called Buffett rule by raising the tax rate on high-income taxpayers.

Advocates of lower tax rates argue that reduced rates would increase economic growth, increasesaving and investment, and boost productivity (increase the size of the economic pie). Skeptics ofthis view argue that higher tax revenues are necessary for debt reduction, that tax rates on high-

income taxpayers are too low (i.e., they violate the Buffett rule), and that higher tax rates onhigh-income taxpayers would moderate increasing income inequality (change how the economicpie is distributed across families). This report attempts to explore whether or not there is anyevidence of an association between the tax rates of the highest income taxpayers and economicgrowth. The analysis in this report does not provide a comprehensive model to examine all thedeterminants of economic growth. Data are analyzed to illustrate the association between the taxrates of the highest income taxpayers and measures of economic growth. For an overview of thebroader issues of these relationships see CRS Report R42111, Tax Rates and Economic Growth,by Jane G. Gravelle and Donald J. Marples, Tax Rates and Economic Growth, by Jane G. Gravelleand Donald J. Marples.

Throughout the late-1940s and 1950s, the top marginal tax rate was typically above 90%; today itis 35%. Additionally, the top capital gains tax rate was 25% in the 1950s and 1960s, 35% in the1970s; today it is 15%. The real GDP growth rate averaged 4.2% and real per capita GDPincreased annually by 2.4% in the 1950s. In the 2000s, the average real GDP growth rate was1.7% and real per capita GDP increased annually by less than 1%. This analysis finds noconclusive evidence, however, to substantiate a clear relationship between the 65-year reductionin the top statutory tax rates and economic growth. Analysis of such data conducted for this reportsuggests the reduction in the top tax rates has had little association with saving, investment, orproductivity growth. It is reasonable to assume that a tax rate change limited to a small group oftaxpayers at the top of the income distribution would have a negligible effect on economicgrowth. For instance, the tax revenue projected from allowing the top tax rates to rise to their pre-2001 levels is $49 billion for 2013 or 0.3% of projected 2013 gross domestic product.

The top tax rate reductions appear to be associated with the increasing concentration of income at

the top of the income distribution. The share of income accruing to the top 0.1% of U.S. familiesincreased from 4.2% in 1945 to 12.3% by 2007 before falling to 9.2% during to the 2007-2009recession. During a portion of that time period, however, the share of the tax burden borne by toptaxpayers increased. For instance, the top 0.1% of taxpayers paid 9.4% of all income taxes in1996 and 11.8% in 2006, but their share of income paid in taxes decreased from 33% in 1996 to25% in 2006.


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Contents

Top Tax Rates Since 1945 ................................................................................................................ 2Top Statutory Tax Rates and the Economy ...................................................................................... 4

Methods ..................................................................................................................................... 5Saving and Investment .............................................................................................................. 6Productivity Growth .................................................................................................................. 9Real Per Capita GDP Growth .................................................................................................... 9

Top Statutory Tax Rates and the Distribution of Income ............................................................... 11Concluding Remarks ..................................................................................................................... 17

Figures

Figure 1. Average Tax Rates for the Highest-Income Taxpayers, 1945-2009 ................................. 3Figure 2. Top Marginal Tax Rate and Top Capital Gains Tax Rate, 1945-2010 .............................. 4Figure 3. Private Saving, Investment, and the Top Tax Rates, 1945-2010 ...................................... 8Figure 4. Labor Productivity Growth Rates and the Top Tax Rates, 1945-2010 ............................. 9Figure 5. Real Per Capita GDP Growth Rate and the Top Tax Rates, 1945-2010 ......................... 11Figure 6. Shares of Total Income of the Top 0.1% and Top 0.01% Since 1945 ............................ 13Figure 7. Share of Total Income of Top 0.1% and the Top Tax Rates, 1945-2010 ........................ 14Figure 8. Share of Total Income of Top 0.01% and the Top Tax Rates, 1945-2010 ...................... 15Figure 9. Labor Share of Income and the Top Tax Rates, 1945-2010 ........................................... 16

Tables

Table A-1. Regression Results: Economic Growth ........................................................................ 21Table A-2. Regression Results: Income Inequality ........................................................................ 22

Appendixes

Appendix. Data and Supplemental Analysis .................................................................................. 18

Contacts

Author Contact Information........................................................................................................... 22


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Taxes and the Economy: An Economic Analysis of the Top Statutory Tax Rates Since 1945

Congressional Research Service 1

f current fiscal policies continue, the United States could be facing a debt level approaching200% of gross domestic product (GDP) by 2037.1 The current policy challenge is a trade-offbetween the benefits of beginning to address the long-term debt situation and risking damage

to a still fragile economy by engaging in contractionary fiscal policy.2 In the long term, manyargue that debt reduction will eventually become the top priority. Ultimately, debt reduction

would require increased tax revenues, reduced government spending, or a combination of the two.If increased tax revenue is part of long-term deficit reduction, expanding the tax base, raising taxrates, or a combination of the two would be required.

Income tax rates are at the center of many recent policy debates over taxes. On the one hand,some argue that raising tax rates, especially on higher income taxpayers, to increase tax revenuesis part of the solution for long-term debt reduction. For example, in the 112th Congress the Senatepassed the Middle Class Tax Cut Act (S. 3412), which would allow the 2001 and 2003 Bush-eratax cuts to expire for taxpayers with income over $250,000 ($200,000 for single taxpayers).3 Onthe other hand, others argue that maintaining low tax rates is necessary to foster economicgrowth. For example, the House passed the Job Protection and Recession Prevention Act of 2012(H.R. 8), which would extend the 2001 and 2003 Bush-era tax cuts for one year.4 Additionally,

some argue that higher income tax rates on high income taxpayers could make the overall taxsystem more progressive.5 The Senate also considered legislation, the Paying a Fair Share Act of2012 (S. 2230), that would implement a version of the Buffett rule by raising the tax rate onhigh-income taxpayers.6

Other recent budget and deficit reduction proposals would reduce tax rates. The Presidents 2010Fiscal Commission recommended reducing the budget deficit and tax rates by broadening the taxbasethe additional revenues from broadening the tax base would be used for deficit reductionand tax rate reductions.7 The plan advocated by House Budget Committee Chairman Paul Ryan,thePath to Prosperity, also proposes to reduce income tax rates by broadening the tax base. Bothplans would broaden the tax base by reducing or eliminating tax expenditures.8

1 Congressional Budget Office (CBO), The 2012 Long-term Budget Outlook, June 2012.2 See CRS Report R41849, Can Contractionary Fiscal Policy Be Expansionary?, by Jane G. Gravelle and Thomas L.Hungerford.3 See CRS Report R42020, The 2001 and 2003 Bush Tax Cuts and Deficit Reduction , by Thomas L. Hungerford for ananalysis of the tax cuts, which are often referred to as the Bush-era tax cuts.4 These tax cuts were extended in 2010 for two years with the enactment of the Tax Relief, Unemployment InsuranceReauthorization, and Job Creation Act of 2010 (P.L. 111-312), which was signed by President Obama on December 17,2010.5 Peter Diamond and Emmanuel Saez, The Case for a Progressive Tax: From Basic Research to PolicyRecommendations,Journal of Economic Perspectives, vol. 25, no. 4 (Fall 2011), pp. 165-190. The progressivity of atax system refers to the degree the average tax rate changes as income increases. If the average tax rate increases asincome increases, then the tax system is said to be progressive.6 See CRS Report R42043,An Analysis of the Buffett Rule, by Thomas L. Hungerford. Generally, the Buffett rule

refers to a policy mandate that no household making over $1 million annually should pay a smaller share of its incomein taxes than middle-class families pay.7 The National Commission on Fiscal Responsibility and Reform, The Moment of Truth, December 2010 available athttp://www.fiscalcommission.gov/sites/fiscalcommission.gov/files/documents/TheMomentofTruth12_1_2010.pdf.8 For more information on tax expenditures, see CRS Report RL34622, Tax Expenditures and the Federal Budget, byThomas L. Hungerford; and Thomas L. Hungerford, Tax Expenditures: Good, Bad, or Ugly?, Tax Notes, vol. 113,no. 4 (October 23, 2006), pp. 325-334. Recent analysis suggests that there are impediments to base broadening bymodifying tax expenditures, which would not allow for significant reductions in tax rates. See CRS Report R42435,The Challenge of Individual Income Tax Reform: An Economic Analysis of Tax Base Broadening, by Jane G. Gravelle(continued...)

I


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Advocates of lower statutory tax rates argue that reduced rates would increase economic growth,increase saving and investment, and boost productivity. Skeptics of this view argue that higher taxrevenues are necessary for debt reduction, that tax rates on high-income taxpayers are too low(i.e., they violate the Buffett rule), and that higher tax rates on high-income taxpayers wouldmoderate increasing income inequality. This report examines top statutory individual income tax

rates since 1945 in relation to these arguments and seeks to explore what, if any, associationexists between the top statutory tax rates and economic growth.9 The analysis examines thecorrelation between the top tax rates and economic growth rather than the causal relationship. Thenature of these relationships, if any, is explored using statistical analysis. 10

The analysis is limited to the post-World War II period. Using this period provides an adequatesample for the multivariate regression analysis that is used to examine correlation. The topstatutory tax rates are examined because the current Congressional debate over the fate of the2001 and 2003 Bush-era tax cuts focuses on the statutory tax rates affecting the highest incometaxpayers. For an overview of the broader issues of these relationships see CRS Report R42111,Tax Rates and Economic Growth, by Jane G. Gravelle and Donald J. Marples.

Top Tax Rates Since 1945

Tax policy analysts often use two concepts of tax rates. The first is the marginal tax rate or the taxrate on the last dollar of income. If a taxpayers income were to increase by $1, the marginal taxrate indicates what proportion of that dollar would be paid in taxes. The highest marginal tax rateis referred to as the top marginal tax rate. How much an additional dollar is taxed depends on if itis ordinary income (e.g., wages) or capital gains. The second concept of tax rates is the average oreffective tax rate, which is the proportion of all income that is paid in taxes. An examination ofthe trend in the average tax rate provides information on how the tax burden has changed overtime.

Although the statutory top marginal tax rate was over 90% in the 1950s, the average tax rate forthe highest income taxpayers was much lower. The average tax rates at five-year intervals since1945 for the top 0.1% and top 0.01% of taxpayers are shown in Figure 1. The average tax rate forthe top 0.01% (one taxpayer in 10,000) was about 60% in 1945 and fell to 24.2% by 1990. Theaverage tax rate for the top 0.1% (one taxpayer in 1,000) was 55% in 1945 and also fell to 24.2%by 1990, following a similar downward path as the tax rate for the top 0.01%. Between 1990 and1995, the average tax rate for both the top 0.1% and top 0.01% increased to about 31%. After1995, the average tax rate for the top 0.01% was lower than that for the top 0.1%. The reductionsin the average tax rates are likely due to both to reductions in the statutory tax rates and changesin the tax base.

(...continued)

and Thomas L. Hungerford.9 The analysis in this report does not examine the effect of taxes on individual components of the economy and itsgrowth, such as small businesses. For a discussion of how the expiration of the Bush-era tax cuts could effect small

business see CRS Report R41392, Small Business and the Expiration of the 2001 Tax Rate Reductions: EconomicIssues, by Jane G. Gravelle and Sean Lowry.10 Finding a correlation between two variables does not mean that a change in one variable causes the other variable tochange.


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Figure 2. Top Marginal Tax Rate and Top Capital Gains Tax Rate, 1945-2010

20

40

60

80

100

Percentage

1945 1950 19551960 1965197019751980 198519901995 2000 2005 2010

Year

Top Marginal Tax Rate Top Capital Gains Tax Rate

Source: Internal Revenue Service.

The variation in the top capital gains tax rate since 1945 has been much lower and there appearsto be no distinctive trend (the lower, dashed line). The top capital gains tax rate was 25% before1965, was raised to 35% in the 1970s, fell to 20% in the early 1980s, and rose to 28% after the

enactment of TRA86. The rate was reduced to its current level of 15% (from 20%) by the Jobsand Growth Tax Relief Reconciliation Act of 2003 (JGTRRA; P.L. 108-27). The top capital gainstax rate is scheduled to return to 20% at the end of 2012.

Top Statutory Tax Rates and the Economy

Some economists and policymakers argue that reducing the top statutory marginal tax rates wouldspur economic growth.12 This effect could work through several mechanisms. First, lower taxrates could give people more after-tax income that could be used to purchase additional goods andservices.13 This is a demand-side argument and is often invoked to support a temporary taxreduction as an expansionary fiscal stimulus. Second, reduced tax rates could boost saving and

12 See, for example, The National Commission on Fiscal Responsibility and Reform, The Moment of Truth, December2010, p. 28. Support for this assertion often comes from theoretical textbook treatments, such as Robert J. Barro,

Macroeconomics, 2nd ed. (New York: John Wiley & Sons, 1984).13 Recent research suggests that the relationship between upper income tax changes and growth is negligible inmagnitude and substantially weaker than equivalently sized tax changes for the bottom 90%. See Owen Zidar, TaxCuts for Whom? Heterogeneous Effects of Income Tax Changes on Growth & Employment, University of California,Berkeley, October 2012, p. 20, http://ssrn.com/abstract=2112482.


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The first method is to estimate the simple bivariate correlation or relationship.18 The simplebivariate relationship is illustrated with a series of scatter diagrams in which each point representsthe top statutory tax rate and a measure of economic growth for a particular year (from 1945 to2010).

The second method is multivariate time-series regression analysis, which estimates therelationship between two variables holding the values of other variables constant. The regressionequations that are estimated have been used by other researchers and are described in theAppendix.

The research and analysis presented in this report seeks to explore what, if any, association existsbetween the top statutory tax rates and economic growth. The analysis in this report does notprovide a comprehensive model to examine all the determinants of economic growth. The dataused for the analysis includes information from 1945 to 2010 and contain 66 observations.19Common issues often associated with time-series analysis are addressed as described in theAppendix.

Saving and Investment

Some analysts caution against a low saving rate. They argue that high capital investment leads tohigher economic growth and a higher future standard of living. But if capital investment is notfinanced by national saving it has to be financed by borrowing abroad.20 Persistent borrowingfrom abroad builds up international liabilities and implies increasing flow of funds will be sentabroad as interest and dividends.

National saving is composed of two components: private saving and public saving. Private savingis the saving by households and businesses while public saving is the budget surpluses of local,state, and federal governments. If spending is greater than income, then saving is negative (i.e.,people are reducing wealth or borrowing).

From a theoretic economic perspective, the effect of taxes on private saving is ambiguous. Iftaxes are reduced, the after-tax return on saving is larger; consequently, individuals may be ableto maintain a target level of wealth and save less (wealth will grow due to the higher after-taxreturns). This is the income effect and has lower taxes leading to less saving. However, thereduced after-tax return changes the relative price of consuming now (saving less) and futureconsumption (saving more) in favor of future consumption. This is the substitution effect and haslower taxes leading to more saving. The actual effect of a tax reduction depends on the relativemagnitudes of the income and substitution effects.21

(...continued)

rate of all taxpayers) has also varied within a narrow band around 15% since 1960 (standard deviation is 2.4). Theaverage tax rate and average marginal tax rate are available at http://users.nber.org/~taxsim/allyup.18 Correlation, relationship, and association are used interchangeably in this report.19The use of other data sets and methods may result in different conclusions. The results of the analysis in this reportare generally consistent with some but not all of the literature in this area, which is cited throughout this report.20 Edward Gramlich, The Importance of Raising National Saving, the Benjamin Rush Lecture, Dickinson College,PA., March 2, 2005.21 See Richard A. Musgrave, The Theory of Public Finance: A Study in Public Economy (New York: McGraw-HillBook Company, 1959).


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The simple relationships between the private saving ratio and the top tax rates are displayed in thetop two charts in Figure 3.22 Each point represents the private saving ratio and top tax rate foreach year since 1945. The nature of the relationship is illustrated by the straight line in the figure,which graphically represents the correlation (fitted relationship or fitted values) between the twovariables.23 The slope of the fitted values line indicates how one variable changes when the other

variable changes. For both the top statutory marginal tax rate and the top statutory capital gainstax rate there seems to be a positive relationshipthe higher the tax rate, the higher the savingratio. The observed correlation between the tax rates and the saving ratio, however, could becoincidental or spurious. To explore these relationships further, CRS conducted a regressionanalysis (see Table A-1) controlling for other factors affecting saving and paying particularattention to the statistical properties of the variables. Results of the regression analysis suggestthat the relationship observed in Figure 3 is likely coincidental (and not statisticallysignificant)suggesting the top statutory tax rates are not associated with private saving.24 Otherresearch suggests that taxes generally have had a negligible effect on private saving.25 But publicsaving can be reduced if tax revenue is reduced due to tax rate reductions. The overall effect oftax reductions on national saving could be negativethat is, national saving falls.26

Taxes can affect investment not only through the income and substitution effects related tosaving, but also through a risk-taking effect. The capital gains tax rate has been singled out asbeing important to investment. For risk-averse investors, the capital gains tax could act asinsurance for risky investments by reducing the losses as well as the gainsit decreases thevariability of investment returns.27 Consequently, a rise in the capital gains top rate could increaseinvestment because of reduced risk.

The bottom charts in Figure 3 show the observed relation between the private fixed investmentratio (investment divided by potential GDP) and the top tax rates. The fitted values suggest thereis a negative relationship between the investment ratio and top tax rates. But regression analysisdoes not find the correlations to be statistically significant (see Table A-1) suggesting that the topstatutory tax rates do not necessarily have a demonstrably significant relationship with

investment.

28

22 The saving ratio is the ratio of private saving to potential GDP (the level of GDP attainable when resources are fullyemployed). Potential GDP is used rather than actual GDP so variation in the saving ratio is due mostly to changes in

private saving rather than to changes in private saving and/or GDP.23 The fitted values are the points on the straight line that best characterize the relationship between two variables.24 The regression results are reported in Table A-1. Also see CRS Report R42111, Tax Rates and Economic Growth, byJane G. Gravelle and Donald J. Marples.25 Eric Engen, Jane Gravelle, and Kent Smetters, Dynamic Tax Models: Why They Do the Things They Do,NationalTax Journal, vol. 50, no. 3 (September 1997), pp. 631-656; Organisation for Economic Co-operation and Development,Tax and the Economy: A Comparative Assessment of OECD Countries, Tax Policy Studies No. 6, 2001; and B.

Douglas Bernheim, Taxation and Saving, inHandbook of Public Economics, ed. Alan J. Auerbach and MartinFeldstein, vol. 3 (Amsterdam: Elsevier, 2002), p. 1173-1249.26 See Edward F. Denison, Trends in American Economic Growth, 1929-1982 (Washington: The Brookings Institution,1985); and CRS Report RL33482, Saving Incentives: What May Work, What May Not, by Thomas L. Hungerford.27 Leonard F. Burman,Labyrinth of Capital Gains Tax Policy: A Guide for the Perplexed(Washington: BrookingsInstitution Press, 1999).28 For further evidence see CRS Report R42111, Tax Rates and Economic Growth, by Jane G. Gravelle and Donald J.Marples; and Christina D. Romer and David H. Romer, The Incentive Effects of Marginal Tax Rates: Evidence from the

Interwar Era, National Bureau of Economic Research, Working Paper 17860, February 2012.


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CRS-8

Figure 3. Private Saving, Investment, and the Top Tax Rates, 1945-2010

.04

.06

.08

.1

.12

.14

Pe

rcentage

20 40 60 80 100

Top Marginal Tax Rate

Private Saving as a Percentage of Potential GDP

Fitted values

.04

.06

.08

.1

.12

.14

Pe

rcentage

15 20 25 30 35

Top Capital Gains Tax Rate

Private Saving as a Percentage of Potential GDP

Fitted values

.1

.12

.14

.16

.18

P

ercentage

20 40 60 80 100


Investment as a Percentage of Potential GDP

Fitted values

.1

.12

.14

.16

.18

P

ercentage

15 20 25 30 35


Investment as a Percentage of Potential GDP

Fitted values

Source: CRS analysis.


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Productivity Growth

Productivity can increase due to investment, innovation, improvement in labor skills, increases inentrepreneurship, and enhanced competition.29 It is often argued that lower tax rates have a

positive effect on all of these factors. Consequently, it would be expected that lower tax ratesenhance productivity growth. Figure 4 displays the relationship between labor productivitygrowth and the top tax rates. The fitted values suggest that the top marginal tax rate has a slightpositive association with productivity growth while the top capital gains tax rate has a slightnegative association with productivity growth. The regression analysis, however, does not findeither relationship to be statistically significant (see Table A-1), suggesting the top tax rates arenot necessarily associated with productivity growth.

Figure 4. Labor Productivity Growth Rates and the Top Tax Rates, 1945-2010

-.02

0

.02

.04

.06

.08

Percentage

20 40 60 80 100


Productivity Growth

Fitted values

-.02

0

.02

.04

.06

.08

Percentage

15 20 25 30 35


Productivity Growth

Fitted values


Note: The vertical axis is the labor productivity growth rate.

Real Per Capita GDP Growth

The annual real per capita GDP growth rate plotted against the top marginal tax rate and topcapital gains tax rate is shown in Figure 5. Each point represents the real per capita GDP growth

29 Office of National Statistics, The ONS Productivity Handbook, Basingstoke, Hampshire, UK, 2007, Ch. 3,http://www.ons.gov.uk.


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rate and tax rate for each year since 1945. The fitted values seem to suggest that higher tax ratesare associated with slightly higher real per capita GDP growth rates. The top marginal tax rate inthe 1950s was over 90%, and the real GDP growth rate averaged 4.2% and real per capita GDPincreased annually by 2.4% in the 1950s. In the 2000s, the top marginal tax rate was 35% whilethe average real GDP growth rate was 1.7% and real per capita GDP increased annually by less

than 1%.

The scattered points, however, generally are not close to the fitted values line indicating that theassociation between GDP growth and the top tax rates is not strong.30 Furthermore, the observedpositive association between real GDP growth and the top tax rates shown in the figure could becoincidental or spurious because of changes to the U.S. economy over the past 65 years.31 Thestatistical analysis using multivariate regression (reported in Table A-1) does not find that eithertop tax rate has a statistically significant association with the real GDP growth rate.32

These results are generally consistent with findings in other current research on tax cuts. Somestudies find that a broad based tax rate reduction has a small to modest, positive effect oneconomic growth.33 Other studies have found that a broad based tax reduction, such as the Bush-

era tax cuts, has no effect on economic growth.

34

It would be reasonable to assume that a tax ratechange limited to a small group of taxpayers at the top of the income distribution would have anegligible effect on economic growth.35 For instance, the tax revenue projected from allowing thetop tax rates to rise to their pre-2001 levels is $49 billion for 2013 or 0.3% of projected 2013gross domestic product.36

30 Also see CRS Report R42111, Tax Rates and Economic Growth, by Jane G. Gravelle and Donald J. Marples.31 Immediately after World War II, the U.S. was the dominant world economy. This dominant position was graduallyreduced as the European and Asian economies recovered and U.S. current account deficits grew.32 Statistical significance provides information on the likelihood a result occurs by chance.33 Eric Engen and Jonathan Skinner, Taxation and Economic Growth, National Tax Journal, vol. 49, no. 4(December 1996), pp. 617-642; and Charles W. Calomiris and Kevin A. Hassett, Marginal Tax Rate Cuts and thePublic Tax Debate,National Tax Journal, vol. 55, no. 1 (March 2002), pp. 119-131.34 Martin Feldstein and Douglas W. Elmendorf, Budget Deficits, Tax Incentives, and Inflation: A Surprising Lessonfrom the 1983-1984 Recovery, in Tax Policy and the Economy, ed. Lawrence H. Summers, vol. 3 (Cambridge, MA:MIT Press, 1989), pp. 1-23; William G. Gale and Samara R. Potter, An Economic Evaluation of the Economic Growthand Tax Relief Reconciliation Act of 2001,National Tax Journal, vol. 55, no. 1 (March 2002), pp. 133-186; and

William G. Gale and Peter R. Orszag, Economic Effects of Making the 2001 and 2003 Tax Cuts Permanent,International Tax and Public Finance, vol. 12 (2005), pp. 193-232.35 It has been suggested that, as more income was concentrated among high-income taxpayers after 1980, changes inthe top statutory tax rates may have affected more income and consequently had an effect on economic growth. As a

part of the data analysis conducted for this report, multivariate regression analysis that allows the coefficient estimatesof the tax rate variables to be different before and after 1980 produces no evidence that the relation between the top taxrates and economic growth was different before and after 1980.36 CRS calculations based on revenue estimates prepared by the Joint Committee on Taxation and economic projections

prepared by the Congressional Budget Office.


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Figure 5. Real Per Capita GDP Growth Rate and the Top Tax Rates, 1945-2010

-.1

-.05

0

.05

.1

Percentage

20 40 60 80 100


Real Per Capita GDP Growth Rate

Fitted values

-.1

-.05

0

.05

.1

Percentage

15 20 25 30 35


Real Per Capita GDP Growth Rate

Fitted values


Note: The vertical axis is the real per capita GDP growth rate.

Top Statutory Tax Rates and the Distribution ofIncome

It is recognized that measures of U.S. income disparities have increased over the past 35 years.37According to income tax data, average inflation-adjusted or real income increased by 116% (thatis, about doubled) since 1945.38 Average real income increased by 395% for the top 0.1% and by692% for the top 0.01% over this period. Average real income for the balance of the top 1% in theincome distribution (i.e., all but the top 0.1%) increased by about 165%. The share of incomegoing to the top 1% increased from 12.5% in 1945 to 19.8% in 2010. Three-quarters of thisincrease in income share went to the top 0.1%. Since the major changes in the distribution ofincome were largely due to changes in the top 0.1% of the income distribution, the focus of theanalysis is on the top 0.1%.

37 CBO, Trends in the Distribution of Income Between 1979 and 2007, October 2011; CRS Report R42131, Changes inthe Distribution of Income Among Tax Filers Between 1996 and 2006: The Role of Labor Income, Capital Income, andTax Policy, by Thomas L. Hungerford; and CRS Report R42400, The U.S. Income Distribution and Mobility: Trendsand International Comparisons, by Linda Levine.38 Thomas Piketty and Emmanuel Saez, Income Inequality in the United States, 1913-1998, Quarterly Journal of

Economics, vol. 118, no. 1 (February 2003), pp. 1-39, with updated tables available at http://elsa.berkeley.edu/~saez/.


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The tax burden has shifted slightly in recent years. Between 1996 and 2006, the average inflation-adjusted tax paid by taxpayers in the top 0.1% increased by 33% (from $1,398,857 to $1,860,790)while their average before-tax income increased by 75% (from $4,275,339 to $7,512,538).Overall, the top 0.1% of taxpayers paid 9.4% of all income taxes in 1996 and 11.8% in 2006.39Thus, the share of the tax burden borne by these top taxpayers has increased while their share of

income paid in taxes decreased from 33% in 1996 to 25% in 2006.

Some argue that the rise in income inequality has been exaggerated. For example, Robert Gordonargues that by some measures the rise in inequality may have been overstated because (1) theincrease in inequality has not been steady, with most of the post-1970 rise in income inequalityoccurring before the mid-1990s, and (2) the use of a common price index across income groupsoverstates income growth at the top of the distribution and understates income growth at thebottom.40 He further argues that there was little change in inequality after 1993 in the bottom 99%of the population and the increase in income inequality can be explained by the behavior ofincome in the top 1%. Recent research shows that most measures of income inequality generallyshow an increasing trend since the 1970s, but the extent of the increase varies from measure tomeasure.41

Arguments are offered for and against reducing income inequality. The classic argument againstrising income inequality is often summarized as the rich get richer and the poor get poorer. Thiscan increase poverty, reduce well-being, and reduce social cohesion. Consequently, some arguethat reducing income inequality may reduce various social ills. Some research has found thatlarge income and class disparities adversely affect health and economic well-being.42

In contrast, others point out that average real income has been rising, so while the rich are gettingricher, the poor are not necessarily getting poorer. In addition, many argue that some incomeinequality is necessary to encourage innovation and entrepreneurshipthe possibility of largerewards and high income are incentives to bear the risks.43 Many argue that income or socialmobility (i.e., movement within the income distribution) is indicative of a dynamic society andequality of opportunityincome inequality thus reflects temporary short-term income disparitiesrather than long-term social status.44

Using data obtained from one team of researchers, Figure 6 displays the trend in the income(before taxes) share of the top 0.1% (the top solid line in the figure) and the top 0.01% (the lower

39 CRS analysis of the data contained in the 1996 and 2006 Internal Revenue Service Statistics of Income Public UseFiles. The year 2006 was the year before the start of 2007-2009 recession; both 1996 and 2006 were at similar points inthe business cycle.40 Robert J. Gordon,Misperceptions about the Magnitude and Timing of Changes in American Income Inequality,

National Bureau of Economic Research, Working Paper 15351, Cambridge, MA, September 2009.41 See, for example, Richard V. Burkhauser, Shuaizhang Feng, and Stephen P. Jenkins, Using the P90/P10 Index toMeasure U.S. Inequality Trends with Current Population Survey Data: A View from Inside the Census Bureau Vaults,

Review of Income and Wealth, vol. 55, no. 1 (March 2009), pp. 166-185.42 Michael Marmot, The Status Syndrome: How Social Standing Affects Our Health and Longevity (New York: HenryHolt and Co., 2004); Richard G. Wilkinson, Unhealthy Societies: The Afflictions of Inequality (New York: Routledge,1996); Robert Frank,Falling Behind: How Rising Inequality Hurts the Middle-Class (Berkeley, CA: University ofCalifornia Press, 2007); and Gopal K. Singh and Mohammad Siahpush, Widening Socioeconomic Inequalities in USLife Expectancy, 1980-2000,International Journal of Epidemiology, vol. 35 (May 2006), pp. 969-979.43 Donald Deere and Finis Welch, Inequality, Incentives, and Opportunity, Social Philosophy and Policy, vol. 19, no.1 (2002), pp. 84-109.44 Milton Friedman, Capitalism and Freedom (Chicago: University of Chicago Press, 1962), p. 171.


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dashed line) since 1945.45 Under both definitions of the top of the income distribution (i.e., high-income taxpayers), the income shares were relatively stable until the late 1970s and then startedto rise. In 1945, the income share of the top 0.1% was 4.2%, increased to 12.3% by 2007, fellduring the 2007-2009 recession, and started to rise again in 2010.46 The income share of the top0.01% followed the same overall trend.

Figure 6. Shares of Total Income of the Top 0.1% and Top 0.01% Since 1945

0

5

10

15

Percentage

1945 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010

Year

Share of Income of Top 0.1% Share of Income of Top 0.01%

Source: Piketty and Saez.

Note: The vertical axis is the share of total income.

The observed relationship between the top tax rates and the income share of the top 0.1% and thetop 0.01% are displayed in Figure 7 (the top 0.1%) and Figure 8 (the top 0.01%). Under bothdefinitions of high-income taxpayers, the fitted values suggest that there is a strong negativerelationship between the top tax rates and the income shares accruing to families at the top of theincome distribution. These results suggest that as the top tax rates are reduced, the share ofincome accruing to the top of the income distribution increasesthat is, income disparitiesincrease. The regression analysis results reported in Table A-2 show that these relationships are

45 Note that the top 0.1% in the income distribution includes the top 0.01%. These are two different definitions of high-income taxpayers. The top 0.1% represents one family in 1,000 and the top 0.01% represents one in 10,000.46 These trends are consistent with evidence that the income of high-income households has become more cyclicalsince 1980. See Jonathan A. Parker and Annette Vissing-Jorgensen, The Increase in Income Cyclicality of High-Income Households and Its Relation to the Rise in Top Income Shares,Brookings Papers on Economic Activity, Fall2010, pp. 1-55.


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statistically significant. Similar results by other researchers have been obtained for othercountries.47

Figure 7. Share of Total Income of Top 0.1% and the Top Tax Rates, 1945-2010

2

4

6

8

10

12

Percentage

20 40 60 80 100


Share of Income of Top 0.1%

Fitted values

2

4

6

8

10

12

Percentage

15 20 25 30 35


Share of Income of Top 0.1%

Fitted values

Source: CRS analysis of Piketty and Saez data.

Note: The vertical axis is the share of total income.

47 A. B. Atkinson and Andrew Leigh, Top Income in New Zealand 1921-2005: Understanding the Effects of MarginalTax Rates, Migration Threat, and the Macroeconomy,Review of Income and Wealth, vol. 54, no. 2 (June 2008), pp.149-165; and Thomas Piketty, Emmanuel Saez, and Stefanie Stantcheva, Optimal Taxation of Top Labor Incomes: ATale of Three Elasticities, National Bureau of Economic Research, Working Paper 17616, November 2011.


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Figure 9. Labor Share of Income and the Top Tax Rates, 1945-2010

.64

.66

.68

.7

.72

Percentage

20 40 60 80 100


Labor Share Fitted values

.64

.66

.68

.7

.72

Percentage

15 20 25 30 35


Labor Share Fitted values


Note: The vertical axis is the share of national income accruing to labor.

Tax policy affects after-tax income. Since the U.S. individual income tax is a progressive taxsystem, after-tax incomes tend to be more equally distributed than before-tax income.52 Changes

in tax policy would change the distribution of after-tax income. Research has demonstrated thattax policy has a less equalizing effect now than it did in the mid-1990s and in 1979.53

The results suggest that pre-tax incomes tend to be more equally distributed and labors share ofincome larger when the top tax rates are higher. Thomas Piketty, Emmanuel Saez, and StefanieStantcheva argue that high top tax rates were part of the institutional structure that restrained topincome by reducing gains from bargaining or rent extraction by CEOs and managers.54 Forexample, a CEO has less incentive to bargain hard over additional compensation when he keeps 9cents of every additional dollar (a 91% top tax rate) than when he keeps 65 cents of everyadditional dollar (a 35% top tax rate). A study by Jon Bakija, Adam Cole, and Bradley Heimprovides additional support for this mechanism60% of taxpayers in the top 0.1% are in

52 CBO, Trends in the Distribution of Household Income Between 1979 and 2007, October 2011.53 Thomas Piketty and Emmanuel Saez, How Progressive in the U.S. Federal Tax System? A Historical andInternational Perspective,Journal of Economic Perspectives, vol. 21, no. 1 (Winter 2007), pp. 3-24; CBO, Trends inthe Distribution of Household Income Between 1979 and 2007, October 2011; and CRS Report R42131, Changes inthe Distribution of Income Among Tax Filers Between 1996 and 2006: The Role of Labor Income, Capital Income, andTax Policy, by Thomas L. Hungerford.54 Thomas Piketty, Emmanuel Saez, and Stefanie Stantcheva, Optimal Taxation of Top Labor Incomes: A Tale of Three

Elasticities, National Bureau of Economic Research, Working Paper 17616, November 2011.


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occupations that provide some bargaining power over compensation (executives, managers,supervisors, and financial professions).55

Concluding Remarks

The top statutory income tax rates have changed considerably since the end of World War II.Throughout the late-1940s and 1950s, the top marginal tax rate was typically above 90%; today itis 35%. Additionally, the top capital gains tax rate was 25% in the 1950s and 1960s, 35% in the1970s; today it is 15%. Statutory tax rates affecting taxpayers at the top of the income distributionare currently at their lowest levels since the end of the second World War. Whether or not the topstatutory tax rates should be raised at the end of 2012, as scheduled under current law, is currentlyan issue before Congress.

The results of the analysis in this report suggest that changes over the past 65 years in the topmarginal tax rate and the top capital gains tax rate do not appear correlated with economicgrowth. The reduction in the top statutory tax rates appears to be uncorrelated with saving,

investment, and productivity growth. The top tax rates appear to have little or no relation to thesize of the economic pie. But as a small proportion of taxpayers are affected by changes in the topstatutory tax rates, this finding is not unexpected.

However, the top tax rate reductions appear to be correlated with the increasing concentration ofincome at the top of the income distribution. As measured by IRS data, the share of incomeaccruing to the top 0.1% of U.S. families increased from 4.2% in 1945 to 12.3% by 2007 beforefalling to 9.2% due to the 2007-2009 recession. At the same time, the average tax rate paid by thetop 0.1% fell from over 50% in 1945 to about 25% in 2009. The statistical analysis in this reportsuggests that tax policy could be related to how the economic pie is slicedlower top tax ratesmay be associated with greater income disparities.

The top statutory tax rates are but one part of a broader debate on the design of the overall taxsystem, which may be taken up in the future. House Ways and Means committee Chair DaveCamp reportedly has said his committee will move a tax reform bill in 2013.56 Many tax reformproposals include changes to the tax base, often through the elimination of tax expenditures, aswell as changes in the tax rates. Broad-based changes to the tax system that significantly affectthe level of total tax revenues could have short-term and long-term effects on the economy.

55 Jon Bakija, Adam Cole, and Bradley T. Heim,Jobs and Income Growth of Top Earners and the Causes of ChangingIncome Inequality: Evidence from U.S. Tax Return Data, Williams College, working paper, November 2010.56 Meg Shreve, Camp Promises Tax Reform Bill in 2013, Tax Notes Today, November 16, 2012.


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Appendix.Data and Supplemental AnalysisFor this analysis, data were gathered from a variety of publicly available sources:

Top marginal tax rates and top capital gains tax rates: IRS, Statistics of Income,various tables available at http://www.irs.gov/taxstats/indtaxstats/0,,id=98123,00.html.

Real per capita GDP, private saving, real private fixed investment, income taxrevenue, real federal current expenditures, real federal transfers, disposablepersonal income, population: Dept. of Commerce, Bureau of Economic Analysis,National Income and Product Account tables, various tables available athttp://www.bea.gov/iTable/index_nipa.cfm.

Labor share of income: calculated from National Income and Product Accounttables, various tables using method of Jos-Vctor Ros-Rull and RaulSantaeulalia-Llopis, Redistributive Shocks and Productivity Shocks,Journal ofMonetary Economics, vol. 57, no. 8 (November 2010), pp. 931-948.

Labor productivity: Dept. of Labor, Bureau of Labor Statistics, available athttp://www.bls.gov/lpc/.

Income shares of top 0.1% and top 0.01%: Thomas Piketty and Emmanuel Saez,Income Inequality in the United States, 1913-1998, Quarterly Journal ofEconomics, vol. 118, no. 1 (February 2003), pp. 1-39, with updated tablesavailable at http://elsa.berkeley.edu/~saez/.

Potential GDP: CBO, available at http://www.cbo.gov/publication/42912.

S&P annual stock returns, real home price index: Robert Shiller, Yale University,available at http://www.econ.yale.edu/~shiller/data.htm.

AAA Bond yield: St. Louis Federal Reserve Bank, available athttp://research.stlouisfed.org/fred2/categories/119.

College graduates: Census Bureau, available at http://www.census.gov/hhes/socdemo/education/data/cps/historical/index.html.

Multivariate time-series regression techniques were used to determine the statistical significanceof the estimated relation between the top statutory tax rates and the various indicators ofeconomic growth. The standard errors were corrected allowing for heteroskedastic andautocorrelated error-term using the Newey-West procedure with 5 lags. All variables were testedfor the presence of a unit root. Most variables were found to have a unit root and these variableswere first differenced for the analysis (i.e., the one year change in the variable is used in theanalysis); none of the variables appear to be cointegrated.57 The specifications and the other

explanatory variables included in the analyses (which are thought to affect the dependentvariables) have been used by other researchers in empirical research and are cited in thedescription of the regression equations below.

57 The variables with a unit root exhibit strong trendsthey are not trend stationary. Regressions of variables with aunit root could find a relationship between two variables that is due to the strong trends rather than to an economicrelationship (called a spurious regression). Thus, the variables were first differenced.


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estimates of the five-year lag and the three-year lag of the tax variables were not statisticallysignificant and the estimates of the other coefficients were little changed from those reported inTable A-1.

A parsimonious model runs the risk of omitting relevant variables from the estimation. If the

omitted variables are correlated with an explanatory variable and the omitted variable has anonzero effect on the dependent variable, then the coefficient estimate of the explanatory variablecould be biased.63 It is unlikely that any omitted variables are correlated with the top statutory taxrates. For example, measures of monetary policy, such as changes in the growth rate of themonetary base, and the average tax rate (two variables that arguably could affect GDP) areuncorrelated with the top statutory tax rates.64 Furthermore, the coefficient estimates of these twovariables when included in the regression for real per capita GDP are not statistically differentfrom zero; the other coefficient estimates are little changed from those reported in Table A-1.

63 William H. Greene,Econometric Analysis, 5th ed. (Upper Saddle River, NJ: Prentice Hall, 2003).64 The correlation of the change in the growth of the monetary base with the top statutory tax rate is 0.031 and with thetop capital gains tax rate is 0.003. The correlation of the average tax rate with the top statutory tax rate is -0.023 andwith the top capital gains tax rate is -0.003.


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other researchers, the one-year lagged real GDP growth rate was included as an explanatoryvariable.65 The results are reported in Table A-2.

Table A-2. Regression Results: Income Inequality

Standard Errors in Parentheses

Change in Log Top 0.1%Share

Change in Log Top0.01% Share Change in Labor Share

Constant 0.0068 0.0073 -0.0055

(1-MTR) 0.6241*

(0.3601)

0.4756*

(0.2483)

-0.0168*

(0.0084)

(1-KTR) 3.7512***

(1.3076)

2.5991***

(0.9598)

-0.0510**

(0.0198)

Lagged Real GDPGrowth

0.0006

(0.0046)

-0.0010

(0.0040)

0.0016***

(0.0001)

F-statistic 3.52 3.30 42.77


Note: - indicates the one-year change in the variable; *** statistically significant at 1% level; ** statisticallysignificant at 5% level; * statistically significant at 10% level.

Author Contact Information

Thomas L. HungerfordSpecialist in Public [email protected], 7-6422

65 The specification was the same as that used by other researchers and similar results were obtained. See A. B.Atkinson and Andrew Leigh, Top Income in New Zealand 1921-2005: Understanding the Effects of Marginal TaxRates, Migration Threat, and the Macroeconomy,Review of Income and Wealth, vol. 54, no. 2 (June 2008), pp. 149-165; and Thomas Piketty, Emmanuel Saez, and Stefanie Stantcheva, Optimal Taxation of Top Labor Incomes: A Taleof Three Elasticities, National Bureau of Economic Research, Working Paper 17616, November 2011.

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